Regulators are Looking at the Accuracy of Advisors' AUM

Have you been diligent about calculating and reporting regulatory AUM for your RIA?

Dan Jameison of InvestmentNews.com put out a great article about an RIA firm that allegedly has mis-calculated assets under management.

The firm was setting AUM at $25 million over the past several years (the former SEC minimum threshold). The assets were not accurate and the state believed that they included assets under their broker-dealer affiliation, which are not assets of the RIA.
The Massachusetts Securities Division has denied registration to this RIA firm and they no longer qualify for SEC registration. Effectively, they are out of business.

Read the full story at InvestmentNews.com

Here is a recap of the current rules related to calculating your RIA's "Regulatory Assets Under Management".
Advisors must quantify the amount of assets they manage. Advisors must calculate "Regulatory Assets Under Management", which is slightly different from the asset calculations you are used to. Here are the key components to the calculation:

Securities Portfolio

Include the securities portfolios for which you provide continuous and regular supervisory or management services as of the filing date. An account is a securities portfolio if at least 50% of the total value of the account consists of securities. For purposes of this 50% test, you may treat cash and cash equivalents (i.e., bank deposits, certificates of deposit, bankers acceptances, and similar bank instruments) as securities.

You must include securities portfolios that are:

1. Your family or proprietary accounts;
2. Accounts for which you receive no compensation for your services; and
3. Accounts of clients who are not United States persons.

For purposes of this definition, treat all of the assets of a private fund as a securities portfolio. For accounts of private funds, include in the securities portfolio any uncalled commitment pursuant to which a person is obligated to acquire an interest in, or make a capital contribution to, the private fund.

Value of Portfolio

Include the entire value of each securities portfolio for which you provide continuous and regular supervisory or management services.

If you provide continuous and regular supervisory or management services for only a portion of a securities portfolio, include as regulatory assets under management only that portion of the securities portfolio for which you provide such services.

• Under management by another person; or
• That consists of real estate or businesses whose operations you “manage” on behalf of a client but not as an investment.

Now that we’ve discussed the two key components, (i) Identifying the Assets; and (ii) Quantifying the Assets - Here’s the How!!
(i) Determine which assets constitute "Continuous and Regular Supervisory or Management Services". You provide continuous and regular supervisory or management services with respect to an account if:

• You have discretionary authority over and provide ongoing supervisory or management services with respect to the account; or
• You do not have discretionary authority over the account, but you have ongoing responsibility to select or make recommendations, based upon the needs of the client, as to specific securities or other investments the account may purchase or sell and, if such recommendations are accepted by the client, you are responsible for arranging or effecting the purchase or sale.

You should consider the following factors in evaluating whether you provide continuous and regular supervisory or management services to an account.

1. The Advisory Contract. If you agree in an advisory contract to provide ongoing management services, this suggests that you provide these services for the account. Other provisions in the contract, or your actual management practices, however, may suggest otherwise.
2. Compensation. If you are compensated based on the average value of the client’s assets you manage over a specified period of time that suggests that you provide continuous and regular supervisory or management services for the account. If you receive compensation in a manner similar to either of the following, that suggests you do not provide continuous and regular supervisory or management services for the account.

• You are compensated based upon the time spent with a client during a client visit; or
 
• You are paid a retainer based on a percentage of assets covered by a financial plan.
• Management practices. The extent to which you actively manage assets or provide advice bears on whether the services you provide are continuous and regular supervisory or management services. The fact that you make infrequent trades (e.g., based on a “buy and hold” strategy) does not mean your services are not “continuous and regular.”

You should consider the following examples in evaluating whether you provide continuous and regular supervisory or management services to an account.Examples of providing continuous and regular supervision:

1. Have discretionary authority to allocate client assets among various mutual funds;
2. Do not have discretionary authority, but provide the same allocation services, and satisfy the criteria set forth in Instruction 5.b.(3);
3. Allocate assets among other managers (a “manager of managers”), but only if you have discretionary authority to hire and fire managers and reallocate assets among them; or
4. You are a broker-dealer and treat the account as a brokerage account, but only if you have discretionary authority over the account.

Examples of NOT providing continuous and regular supervision:

1. Provide market timing recommendations (i.e., to buy or sell), but have no ongoing management responsibilities;
2. Provide only impersonal investment advice (e.g., market newsletters);
3. Make an initial asset allocation, without continuous and regular monitoring and reallocation; or
4. Provide advice on an intermittent or periodic basis (such as upon client request, in response to a market event, or on a specific date (e.g., the account is reviewed and adjusted quarterly).

(ii) Determine the value of those assets identified above:
Determine your regulatory assets under management based on the current market value of the assets as determined within 90 days prior to the date of filing this Form ADV. Determine market value using the same method you used to report account values to clients or to calculate fees for investment advisory services. In the case of a private fund, determine the current market value (or fair value) of the private fund’s assets and the contractual amount of any uncalled commitment pursuant to which a person is obligated to acquire an interest in, or make a capital contribution to, the private fund.
Examples:
You should consider the following examples in calculating your value of Regulatory Assets Under Management.
The client's portfolio consists of the following:

Stocks and Bonds	$6,000,000
Cash and Cash Equivalents	$1,000,000
Non-securities (collectibles, commodities, real estate, etc.)	$3,000,000
Total Assets	$10,000,000

Let’s run through some Key Questions:

1. First, is the account a securities portfolio? The account is a securities portfolio because securities as well as cash and cash equivalents (which you have chosen to include as securities) ($6,000,000 + $1,000,000 = $7,000,000) comprise at least 50% of the value of the account.
2. Second, does the account receive continuous and regular supervisory or management services? The entire account is managed on a discretionary basis and is provided ongoing supervisory and management services, and therefore receives continuous and regular supervisory or management services.
3. Third, what is the entire value of the account? The entire value of the account ($10,000,000) is included in the calculation of the adviser's total regulatory assets under management.

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FINRA off the table for 2012

July 31, 2012

For the moment, FINRA as an Self Regulatory Agency is off the table. H.R. 4624 (the “Investment Adviser Oversight Act of 2012”), which would subject RIA firms to the absurd rule making, inspection and enforcement authority by FINRA, is off the table of this session of Congress.

Not a time for celebrating...

FINRA and its advocates have taken a step back to come up with a better argument and hope the SEC makes no progress on funding, increased exam coverage and credibility. Expect to see this come back in the next session!

As a lesser of two evils, the discussion on RIA Exam Fees is back in circulation. 

On July 25, 2012, Rep. Maxine Waters (D-Calif.) proposed a bill that would would permit the SEC to impose user fees on SEC-registered investment advisors (note SEC only) that will be used solely to enhancing the SEC's examination program.

We see this as a likely reality that more fees are in store for advisors. This will also pave the way for states to implement exam fees.

Sadly, we have yet to see a bill that suggests the SEC actually review its methodology. 

That's politics. We'll keep you apprised of the developments.

February, 2013 Update

Citing a lack of "strong momentum," FINRA has stepped out of the ring and has backed off their efforts to convince Congress that they should oversee registered investment advisors. No doubt they are strategizing on their next move so we will most likely see them resurface at some point. Our view remains that FINRA's long term approach to regulating broker dealers and registered representatives is not a good fit for regulating fiduciaries.

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Changes to Form ADV Part 1

A new version of Form ADV Part 1 was released by FINRA on November 7, 2011.

The next time your firm logs onto the IARD system to file an amendment to your Form ADV Part 1, you will be prompted to answer several new questions and also confirm (re-answer) certain existing questions

Below we have listed the Items that have been updated and summarized many of the changes that were implemented (We focus on the significant changes here. To be certain that your RIA addresses all of the updates thoroughly, it would be best to review with your compliance consultant or attorney.).

Item 1
Item 1 specifically asks advisors to identify contact information for the firm’s Chief Compliance Officer and also provides an option to include one additional regulatory contact person.

Advisors are also now asked the following questions:

• Are you a public reporting company under Sections 12 or 15(d) of the Securities Exchange Act of 1934? If "yes," provide your CIK number.
• Did you have $1 billion or more in assets on the last day of your most recent fiscal year?
• Provide your Legal Entity Identifier if you have one?

Item 5
ADV Part 1 Item 5 now asks that advisors specifically identify the exact number (as opposed to ranges) of employees that fall into each functional category. We believe that this was partially motivated by an interest in adding clarity to staffing levels among the increasingly large number of smaller RIAs.

This section also now asks advisors about the “percentage of clients that fall into various categories”. The previous version of ADV Part 1 asked only for the approximate percentage that each type of client comprised of the total number of clients. The new version requests the same breakdown but also asks for the approximate amount of regulatory assets under management (reported in Item 5.F. of ADV Part 1) attributable to each type of client.

Advisors should note that the list of client types was expanded and now includes “business development companies,” “other investment advisers”, and “insurance companies.” This higher level of granularity will likely reduce reliance on the "other" category, and improving transparency to investors.

Item 5 also asks advisors to disclose what percentage of their clients are non-United States persons.

Item 6 and Item 7
Working with our clients in the past, we have noticed frequent confusion around the differences between Item 6 and Item 7 of ADV Part 1, specifically regarding when a “business activity” impacts Item 6 versus Item 7.

The list of “business activities” in each of these sections has doubled. While this expansion will likely alleviate some confusion, advisors should carefully review this updated list (particularly the responses related to “broker-dealer” and “registered representatives”.

Item 8
While we’re on the topic, Item 8 now asks for some additional information about your broker-dealer relationships. Specifically, if you have client discretion for broker-dealer selection, Item 8.E. now asks if this broker-dealer a “related person.” This addition further helps identify and disclose potential conflicts of interest.

The new version of the ADV drills down deeper into the benefits that advisors receive from broker-dealers, asking specifically about "soft-dollar benefits." If the advisor does receive "soft-dollar benefits," they are asked to affirm that the service(s) received are eligible under 28(e) of the Exchange Act. This change seems to bifurcate benefits received by participating on an institutional wealth platform and benefits received via soft-dollars.

In addition to asking advisors if they compensate individuals for referrals, the new Item 8 also asks if the advisors themselves are compensated for referrals.

Item 9
For advisors that do have custody of some assets, the new Item 9 drills down into those assets and asks: “If you or your related persons have custody, how many persons, including, but not limited to, you and your related persons, act as qualified custodians for your clients in connection with advisory services?

Item 11
Item 11 relates to disciplinary events. The new version first asks advisors if any of the events described in the disciplinary questions involve you or any of your supervised persons specifically. This broadens the scope of the questions to anyone you supervise.

Item 11 generally requires advisors to describe disciplinary events that involve advisory affiliates, which include:

(1) all current employees (excluding employees performing only clerical, administrative, support or similar functions);

(2) officers, partners, or directors (or any person performing similar functions); and

(3) all persons directly or indirectly controlling you or controlled by you.

If you have any questions about how these changes impact you firm, please do not hesitate to reach out to AdvisorAssist.

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